Corporate Finance - Cost of Capital - Break Points

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gazhoo

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Hi,
Break point = (amount of capital at which the compnents’s cost of capital changes) /
(weight of the component in the capital structure)
Why is the amount of capital divided by the weight of the component in the cap structure?
 
breakpoint was explained very poorly in the CFAI text, but much better in schwesser notes. Check it out.
 
I am looking at Schweser but don’t understand the logic of this…
 
If you capital structure is 40% debt and 60% equity, and for example you have say 5 million debt and 10 million equity available then,
your first breakpoint for debt will occur at
5/40% = 5/0.40= 11.25 million dollars
and first breakpoint for equity will occur at 10/0.6 = 16.67
 
Thanks razedge.
But, I don’t understand the logic of the equation;
Break point = (amount of capital at which the compnents’s cost of capital changes) /
(weight of the component in the capital structure)
Why does this constitute a break point?
 
Gazhoo:
Let’s take Razor’s example:
The reason a breakpoint ocurs is that you have reached a point where you have used up your “cheap capital”. In other words, once you have used up $5 million in debt, you must then pay a higher cost of debt on additional funds (therefore, if cost of debt goes up, so does cost of capital). Since Debt is 40% of total capital, you’re solving for total capital in the equation
$5 Million = (Total Capital) x (weight of debt)
So, Total Capital = $5MM/Weight of Debt = 5/(.40) = 12.5MM
In other words, $12.5MM of total capital is the point where you have just exhausted the $5MM of “cheap” debt.
An identical logic holds for the equity breakpoint.
X in the equation
Total Capital =
If you capital structure is 40% debt and 60% equity, and for example you have say 5 million debt and 10 million equity available then,
your first breakpoint for debt will occur at
5/40% = 5/0.40= 11.25 million dollars
and first breakpoint for equity will occur at 10/0.6 = 16.67
 
Gazhoo:
You are trying to find total capital amount at which you will reach respective nreak points. (Part of total capital comes from debt and part from equity) so if break point is given for say debt, you are trying to find what is the amount of total capital at which break point will change the cost of capital. In the given example if you raise 11.25 million $ then 5 million will come from debt portion (since you are trying to maintain the D/E ratio)
 
oops - disregard everything in my last post after “An identical logic holds for the equity breakpoint.” I forgot to check my work.
AJ: I believe you have a math error - 5/0.40 is 12.5, not 11.25 (speaking as one who also made an error)
 
Oops i did not check the calculations, i assumed 5/0.4=11.25.Anyways…
do you agree with the explaination as that’s what matters…
 
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